Given the significant rand weakness over the last few weeks and the very recent losses on the JSE, some investors are starting to wonder if they should rather invest their money overseas and away from our volatile economy. This type of thinking is very similar to what was experienced in the early 2000s when rand weakness was apparent against all major currencies. Many thought rand weakness would continue to the point where the currency had no value.

History proved those who sent money out of the country to protect against rand weakness at that time made a mistake. Doing so this time might repeat the error.

The JSE protects against rand weakness and US inflation

With the recent rand weakness and all the negativity surrounding the South African economic and political situation, I am often asked whether investors should simply invest their money overseas. This is a completely understandable question. But it might not be your best investment strategy to protect against rand weakness. In my view, unless you think Zumanomics will destroy the SA economy, you must maintain a sizable investment in the JSE to ensure long-term investment success.

Many of the biggest companies on the JSE earn the majority of their money from outside of SA. This means any rand weakness will increase profits, which is positive for their share prices in the longer term.

The fund managers that I believe provide the best investment research, Cannon Asset Managers, created the graph below. It shows the return of the JSE in US$ (green) against the US inflation rate (blue) and the US stock market (red). As you can see, even with the recent rand weakness and the sharp drop in the JSE, SA investors are still handsomely beating the US inflation rate, as well as the US stock market, over the last 10 years.

The graph is interesting because it shows the JSE has beaten US inflation and the US stock market over all the preceding 10-year periods from 2006 until now. (You can also see the JSE underperformed in the 10-year periods from 1997 to 2006.)

Given this information, even the most hardened afro-pessimist would have a hard time arguing that it is always better to invest outside of SA to protect against rand weakness. For me, the graph further illustrates the value of a properly diversified portfolio of shares to give you exposure to the JSE and offshore markets. The primary reason for this diversification is to protect against stock market events that are totally unpredictable, but massively damaging to investors.

How much must I invest offshore?

If you plan to spend your life in SA, I feel you should have an offshore investment allocation that equates to 20% to 40% of your net wealth. It’s important to note that you can get a lot of this offshore allocation via local unit trusts, exchange traded funds (ETFs) and even some of the pure rand hedge shares.

If you are planning to spend a large portion of your time (and therefore your money) outside SA, you should invest 35% to 70% of your money offshore. More importantly, you must invest a significant portion of this money directly overseas, i.e. using your offshore allowance. In so doing you can access the money from overseas when required.

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Uncertainty and volatility can seem scary… don’t let this worry you

The devaluation of the rand. Labour disputes in the mining and agricultural sectors. Concerns about our economic future. These issues all unsettle investors. The fact that the stock market performed well in 2012 is amplifying the fear. Investors worry the market cannot continue going up for longer. Should you be worrying about uncertainty and volatility too? What should really worry you; uncertainty, volatility or inflation?

Volatility is not risk

I always get grumpy when I read marketing material from fund managers. They brag about the low volatility of their funds as if this means their funds are somehow less risky than their competitors’. It’s hogwash to equate uncertainty and volatility to risk. Especially if you are a private person who needs to make smart, long-term investment decisions. If you want to generate real capital growth, pray for uncertainty and volatility. Investments with no uncertainty and volatility are either very low risk and stand little chance of beating inflation, or these are Ponzi schemes.

Uncertainty and volatility give opportunity

Where would you rather invest your money today, in platinum miners or the listed property sector? I’m sure many people prefer listed property. The returns have been great (especially last year). There is a good chance these companies will generate income and profit in the next few years.

What about platinum? The unions seem hell-bent on destroying their source of employment in a lethal game of chicken to get higher wages for a reducing number of employees. Some platinum miners are even being publicly targeted by Government. This is never a good sign for investors. However, if forced to allocate money to only one specific sector today, I would consider platinum miners and not listed property. There is good value in these miners. They have no international competition, so they have a natural monopoly. The uncertainty and volatility facing the sector is precisely what creates the investment opportunity.

Manage uncertainty and volatility, don’t avoid it

Most international markets, including SA, have performed well recently. Uncertainty and volatility has reduced and most equity investors are in a comfort zone. This is probably a good time to start worrying. Complacency coupled with equity investment is never healthy. The chance that equity markets will generate reduced performance in the years ahead is increasing. It will be difficult for most asset classes to beat inflation over the next three to five years.

Am I saying you should sell out of equities? Definitely not. I do recommend you diversify your portfolio across a range of sectors and asset classes. No-one knows if the stock markets will continue to run for the next year or three. I prefer earning dividends and not interest on cash. Optimally diversify your assets in volatile conditions as an effective strategy.

The best investors never invest with absolute conviction. They realise the stock market will always do the unexpected in the short-term. This means they don’t bet the house on one particular strategy. Smart investors allocate some capital to one strategy. But if they’re wrong, they will have capital allocated to other strategies too. They do not take unsustainable losses. Absolute conviction with investment is always fatal to capital growth.

Inflation is your real risk

Over long periods of time the effect of inflation on your money is your real concern. If you don’t invest in productive assets such as shares and commercial property, you are guaranteeing the value destruction of your capital. This is especially true if you invest in cash and other “low risk” assets, because you want to avoid uncertainty and volatility. This is not a good strategy for long-term investing.

Productive assets are by their very nature volatile. Ideally you should focus on the income from these assets. If the income they generate increases faster than the inflation rate, the volatile nature of the capital invested is not relevant. It’s one of the reasons why Warren Buffett avoids IT companies. He cannot predict their income in the next 10 years. Therefore he allocates his capital elsewhere.

If the markets take a beating in the next year or two, I will probably increase my allocation to shares beyond my normal targeted percentage. But I will always maintain some asset class diversification. Just in case.

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The one question I’m asked most often is: “Where is the JSE going next?”. The short answer is I have no idea and nor does anyone else. However, we can use history to provide some guidelines. More specifically, we can use long-term valuations of the JSE to give us our best indication of what to expect in the medium term.

Price/Earnings ratios are instructive

The index level of the JSE All Share Index is a largely meaningless number. In essence it shows the direction and speed at which all share prices are changing on a daily basis. Whether the index is at a level of 22 000 or 40 000 is not really meaningful to long-term investors. What is relevant is how quickly the index level changes over a period of time. For example, if the index drops from 40 000 to 30 000 over a period of six months, long-term investors should start getting interested because they might find bargains.

If the JSE All Share Index is trading close to all time highs, should we infer that the whole stock market is expensive? I don’t think so. Instead, I prefer to look at the price/earnings (PE) ratio of the market to determine when the JSE is starting to look pricey.

The PE ratio of the market tells us how many years of future profits will be required to pay for the price of the market today. The long-term average PE ratio of the market is 14, which means it will take 14 years’ future profits to pay for the market at today’s prices. The graph below shows us the PE ratio of the market from 1998 to 31 January 2013. The solid black line is the long-term PE of 14 and the two dotted lines (above and below the solid line), indicate when the PE has moved significantly above or below this average.

JSE PE Graph 1998 to 2012

It is only when the market value moves above or below these dotted lines that I start to worry about the future direction of the JSE. If the PE rises above the top dotted line, it means the JSE is starting to become expensive. Therefore it is more likely to fall over the medium term than it is to rise. For investors it is a time to be particularly cautious with your money and perhaps consider taking some profits, especially if you are over-invested in shares. At current levels, the All Share Index is near 40 000. But the PE ratio is still below 16, which means it is not expensive.

This does not mean I think the market is cheap, far from it. I believe the market is cheap when the PE drops below 12. At present, some sectors of our market are very expensive and should be treated with caution. Most retailers and international companies are very expensive. New investments into these sectors should be made with great caution. Other sectors of our market are offering good value though. This is why the PE of the whole market is not too high.

Adrian Saville from Cannon Asset Managers points to commodity and domestic industrial firms that have been overlooked by international investors as sectors offering good value. Sectors that are currently in the news for all the wrong reasons, e.g. platinum miners, are offering great value.

We need to remember the PE ratio is an average. Real problems can be hidden by averages. Just like the man who was an average temperature, because he had his head in a fire and his feet in ice. I feel you should treat this market with caution. But there is still value to be found for patient investors.

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Trying to determine whether the JSE is expensive, what is happening to resources, where the rand is going and what further damage politicians will do to our markets is an impossible task. Many investors (and their financial advisors) choose to outsource control of their investments to fund managers of flexible or balanced funds. The belief (or hope) is that the fund manager has a better insight into the future than the rest of us. Frankly, I think these investors (and their advisors) are making a big mistake. Private individuals who control their own asset allocation in a rational and structured way will do much better in the next few years than flexible or balanced funds.

Fund managers make structural errors

Many credible fund managers (not all unit trust managers are credible) make two structural mistakes with their balanced or flexible funds over the long term. Firstly, they are usually under-invested in equities over longer periods of time and secondly, they are almost always under-invested in listed property. The usual explanation from balanced fund managers about their under-investment in shares is that they are protecting investors from potential losses if the stock market drops. A fund manager who remains conservative with equities in a balanced fund over the long term is more likely to keep his job because he won’t have a blow up in a 12 month period. This does not necessarily mean he is doing a good job for his investors.

Listed property is more interesting, it is very rare to find balanced funds with a large exposure to property companies. This is partly because the property sector is quite small in comparison to the rest of the stock market. However this is not the only reason. I have a view (not scientifically proven) that most balanced fund managers are equity managers at heart and are not fundamentally comfortable with listed property. They will take small positions at certain stages in a market cycle but for the rest of the time will avoid property. As you can see from the table below, an underinvestment in property (as shown by property unit trusts) was a very poor decision over the last five years.

Asset Class

Index/Fund Name

5 year annualised returns

Shares

All Share Total Return

8.14% per year

Property

Average of all property unit trusts

12.21% per year

Property

Best Property Unit Trust

16.18% per year

Balanced Funds

Average Balanced Funds

7.14% per year

Balanced Funds

Best Balanced Fund

10.08% per year

Source: Morningstar

One could also infer from the table that the average balanced fund manager was very risk averse over the last five years, in a time when interest rates were declining, which was great for local bonds and listed property.

Take control

For a private investor, there are few limitations on the portion of capital that you can allocate to any asset class. It is unlikely that a very large balanced unit trust will invest 15% or 30% of its capital in listed property because the property sector is too small. This would not be a problem for an individual and so it does not make sense to allocate the bulk of your capital to a balanced fund where you will be limited from investing in quality listed properties. Having said all that, I am not advocating that you place all your money in listed property – far from it. I feel you should create a structural asset allocation for yourself that is not determined by external factors. To start with, if you adopted a really simple approach to asset allocation, you could do the following:

Asset class

Percentage Allocation

Shares

50%

Bonds

25%

Listed Property

25%

TOTAL

100%

The real benefit of this approach is that you determine your allocation to growth assets based on your own situation. It is only by investing in growth assets (equities and listed property) on a sustained basis, that investors will make the maximum possible return without taking excessive risk. If the stock market continues to rise, fund managers are likely to reduce their exposure to shares and listed property even further. This is because they are worried that the market might dip in the short term but a short term dip might not be relevant to you. If you bought quality growth assets at a great price, the fact that they fall for a year or two might be irrelevant if you are investing for 20 years. You might have bought the investments 8 years ago and so a 15% drop from current levels would be small in the context of your overall investment performance.

My preference would be to allocate portions of your capital directly to an equity fund, property fund and bond fund. You can then determine when to rotate asset classes based on your own goals rather than the fund manager’s.

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It is simple but not easy to make R1 million from investing, all you need is: R5,000 per month, some patience and discipline.

The formula

There is no easy way to get rich quick. People who have become wealthy in a short space of time have either gambled or been extremely lucky. Your only guaranteed way to get rich is to follow a few simple (but not easy) steps and be patient for a few years.

Step 1: Get out of debt

You cannot get rich if you have short term debts such as credit cards, clothing accounts and overdrafts. If you really want to become wealthy, you need to pay off these bad types of debt as quickly as possible. Thereafter you can keep your good debts such as home loan and car debt.

Step 2: Build an emergency fund

You need to build up a cash account that is accessible at short notice. Try to keep 3-6 months worth of your monthly expenses in this account. It is not an investment and should only be used to pay for emergencies such as a car breakdown or insurance claim. The purpose of this account is to avoid the situation where you have to sell investments at the wrong time.

Step 3: Start saving

Younger people can invest all their savings in shares because they have the time to let these investments grow. In your lifetime as an investor, you are going to see many stock market crashes and recoveries, your job is to simply keep saving through all of them. Ignore all the people and pundits who will try to scare you out of saving, just keep your head down and stick to the plan. Ideally you should save as much as possible in the beginning. Try to ensure that you save a minimum of R5,000 per month. I realise that R5,000 might seem like a large amount in the beginning but you have to decide – do you want to be financially independent or do you want to work for a salary for the rest of your life? As I mentioned at the start of this article, it is simple but not easy to get rich.

Step 4: Where to invest

The ideal place to start saving is in an exchange traded fund (ETF) or indexed investment. ETF’s are low cost investments that will generate fantastic growth over the long term. If you want to start making a million rand every 2 to 4 years, you will first need some capital. As they say, “Money makes money.” By now, I am sure you are wondering how on Earth you are going to make this kind of money so quickly.

How it works

You need to save R5,000 every month for a period of nine years.

Try to invest all this money in the stock market e.g. in an ETF.

After nine years, you will almost certainly have a R1 million worth of investments.

If you keep investing R5,000 and add it to the first R1 million, you should have another R1 million within 4 years.

By sticking to the plan, you should have your R3m in total within 16 years.

Whilst 16 years might seem like a long time, you can reduce the period by saving more money as your salary increases over time. Any bonuses or other lump sums that you can add to the investment will speed up the process significantly. There is a real-life example below of someone who has saved R750,000 in less than four years.

Why this works

It is possible to save this kind of money because of the growth potential of the share market and the power of compound growth. Since the year 1900, the stock market has generated an average return of 7% above inflation per year, which equates to a nominal return 12.5% per year. That means you don’t need to be a rocket scientist or have any special stock market knowledge to be a successful investor – you just have to be disciplined and patient.

The real-life example

In February 2007 I met a young person who asked me to advise her on how she should start investing. She was 25 years old and had R9,000 to invest every month. We worked out a plan very similar to the one outlined above and she implemented it on her own for the next 3.5 years. In June this year, she emailed me to say that she had more than R700,000 in her share portfolio (primarily ETF’s) and was hoping to have R1m by the time she was 30, she is nearly 29 now. As her career progressed, she started earning very good money at an early stage in her career but she maintained a low-cost lifestyle. She did not buy fancy cars and she continued to rent a small apartment – this was the difficult part of the plan but she did it relatively easily. Most of us would be tempted to start spending more money as our earnings increased, she avoided this trap and is now on her way to financial independence. She is now considering the option of starting her own business in a few years because she will have enough savings to live off. That means she won’t need a job or a boss, she will be financially independent before she is 35 years old. To me, this is the best reason to save when you are young – it gives you the freedom to make great life-changing decisions.

Conclusion

I realise that most people can’t earn the same salary as the person in my example but everyone can follow her formula. As you can see, there is no secret recipe, you just need to save constantly and keep your lifestyle costs in check.

Will you have enough money when you retire? Thinking of investing? Wondering how to repay your debt? Where to invest your money?

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